Tuesday, January 29, 2013

JP Koning wants to know why many of us continue to talk about a safe asset shortage five years after the financial crisis started. Shouldn't this problem corrected itself many years ago? He has asked this questions many times and most recently framed it this way:

Why do we *need* more safe assets? Why don't we just let the existing ones rise in value, thereby providing safety? If
we wanted to express our desire for safety by buying fire
extinguishers, then I'd agree that we need to produce more safe assets.
After all, only some sort of increase in the supply of extinguishers
will be able to meet that demand.

But things are different if we
express our demand for safety by turning to financial markets. The great
thing about t-bonds is that unlike fire extinguishers, we don't need to
fabricate more of them to meet our demands for safety... we just need a
higher real value on the stock of existing t-bonds. This can be
entirely met by shifts in prices. Where is the problem that needs to be
rectified?

This is a great question. Why haven't financial markets--the nimblest, most flexible markets of all--pushed treasury values to levels that would cause the market for safe assets to clear? Shouldn't arbitrage in these markets fixed this problem long ago?

Let me begin my answer by recalling why the ongoing shortage of safe assets is such a big deal. Safe assets facilitate transactions for institutional investors and therefore effectively acts as their money. During the crisis, many of these transaction assets disappeared just as the demand for them was picking up. Since these institutional money assets often backstop retail financial intermediation, the sudden shortage of them also meant a shortage of retail money assets. In other words, the shortage of safe assets matters because it means there is an excess demand for both institutional and retail money assets. This excess money demand, in turn, is keeping aggregate nominal expenditure growth below where it should be.

It is also important to note that although the crisis began in 2007 there has been a series of subsequent shocks that have kept the demand for safe assets elevated: the Euro crisis of 2010-2012, the debt-ceiling talks of 2011, the fiscal cliff of 2012, and concerns about a China slowdown. So there hasn't been for sometime a period of prolonged calm to ease the heightened demand for safe assets. Still, Koning's argument should still hold despite this spate of bad economic news. Safe asset prices should be able to adjust to reflect these developments.

The problem is that safe assets, treasury securities in particular, cannot make this adjustment when they are up against the zero lower bound (ZLB) on nominal interest rates. Given the large shortfall of safe assets, interest rates need to go below 0% for treasury prices to rise enough to satiate the excess demand for them. Investors, however, can earn 0% holding money at the ZLB. Consequently, investors will not purchase enough treasury securities to sufficiently raise treasury prices (i.e. lower interest rates) and clear the market.1

In addition, the heightened economic uncertainty and the ZLB means the demand for these transaction assets (i.e. money and treasuries) becomes almost insatiable. Investors, therefore, shy away from other higher yielding, riskier assets that normally would lure them. Portfolios get overly weighted toward liquid assets.

Note what is happening here: treasuries and money become increasingly close substitutes as they approach the ZLB, while the overall transaction asset market becomes increasingly segmented from other asset markets. In other words, as arbitrage becomes more powerful among transaction assets like money and treasuries, it becomes less powerful between the market for transaction assets and other asset markets. The short answer to Koning's question, then, is that the ZLB has segmented the transaction asset market and this is preventing the safe asset market from clearing.

Below is my initial attempt to show this graphically. It shows that while treasury and money assets substitutability is always responsive to interest rate changes, market segmentation is not and only kicks in after some threshold close to the zero bound is reached. In other words, at some point when treasuries and money become close enough substitutes, the market for transaction assets begins to segment from other markets. Where this actually occurs is unknown and the way I have drawn it is arbitrary. But hopefully you see the point.

P.S. Market Monetarists, including myself, typically downplay the importance of the ZLB for monetary policy. We argue the ZLB is really just an artifact of doing monetary policy with an interest rate; it should have no actual bearing on the efficacy of monetary policy. Here, in the case of the safe asset shortage, it does seem to be a non-trivial phenomenon that needs to be taking seriously.

1Given a sticky price level, the increased holdings of money at the ZLB
will also continue since the price level does not adjust quickly either.

Matthew C. Klein of the Economist and I have been debating how best to address the shortage of safe assets. His view is that fiscal policy alone can solve this problem by creating more safe assets. I, on the other hand, believe that fiscal policy cannot create enough assets to close the safe asset shortfall without jeopardizing the U.S.Treasury's risk-free status. The solution, then, lies with increasing investors' appetite for privately-created safe assets. Should this happen, financial firms would respond by creating the assets needed to close the safe asset gap.

In his latest response, Klein argues that investors' appetite for private assets has already increased to no avail, that the government can create sufficient safe assets with jeopardizing its safe asset status, and that the main story here is most likely a secular shift in safe asset demand, not a cyclical one. I disagree on all counts and believe my approach--catalyzing private safe asset creation through an aggressive NGDP level target--is still the better one to take. Let me explain why.

First, his claim about increased appetite for private assets ignores systematic evidence that shows the risk premium still needs to come down. It is true, as Klein points out, there has been record growth in junk bonds, but this is a small part of the debt market. And yes, CLO issuance is picking up, but it is a pittance of what the market use to be as seen in this IMF figure. In other words, these are movements in the right directions, but the scale is small. If these were significant changes or harbingers of significant changes, risk premiums would be falling but they are not. Let me share two examples that demonstrate this fact. First, consider the risk premium indicated by the spread between Moody's BAA corporate yield and the 10-year treasury yield. Moody's BAA measure is a reflection of the entire corporate bond market at this lowest investment grade level. The figure below shows this spread remains elevated and according to the Survey of Forecasters, it is expected to remain elevated through early 2014.

And yes, this spread is systematically related to expected inflation and the stock market, so it matters. Consequently, a return of the risk premium to its average value would be associated with a pick-up in economic growth.

Another important measure is the equity risk premium. This shows the spread between the S&P 500 earnings yield and the 20-year treasury yield. It too is at an unusually high level as seen below:

This is an important metric for Ed Bradford, a bond trader, who recently noted the following about this risk premium measure:

The equity risk premium (EY - 30 year bond yield) at the end of 2011
rose above 6% and is currently approximately 4%... The recent 4-6% ERPs
are some of the highest levels since 1971. There was only a brief
period in the late 1970s that had similarly high levels of risk premium.
It is notable that the late 1970s episode was also after a brutal bear
market (1973-1974). Most of the time the risk premium has been capped
at 2%. This initial yield differential between equities and fixed
income imply much better returns going forward for equities and very
attractive opportunities for traders to place pair trades between the
two assets classes (equity vs US Treasury bonds)... Assuming corporate
earnings continue to grow and we avoid a recession, I expect the risk
premium to decrease significantly.

In short, the equity risk premium measure is currently too high relative to where it should be given long-run economic fundamentals. So again, there is room for the risk premium to drop and the public to increase its appetite for private assets. When this happens, it should catalyze private safe asset creation.

Second, Klein believes that fiscal policy can almost costlessly create enough assets to close the safe asset shortage. As I noted in my last post, I think this is wrong because of the Triffin dilemma:

[T]he U.S. government faces a tension. It can run larger budget deficits to meet the global demand for safe assets, but doing so may eventually jeopardize its risk-free status, the very thing driving the demand for its securities. This is the modern version of the Triffin dilemma and it reminds us that there is a limit to how much safe asset creation can be done by the government.

This should not be a controversial position. Should investors start dumping treasuries because they fear an implicit default via higher expected inflation, the government would face higher financing costs. As expected inflation increased, the Fed would have to raise interest rates or allow higher inflation to emerge. We are nowhere near this point now, but how do we know that we will not hit it if fiscal policy tries to completely satiate the demand for safe assets?

Third, Klein's arguments seem to be premised on a view that what is driving the increased demand for safe assets is largely a change in secular demand, rather than a cyclical response to the economic downturn. If so, then, the elevated risk premium would be the new norm. This is a reasonable point, as an aging global population, changes in accounting practices for pension funds, and the Asia-oil exporters' saving glut all put downward pressure on the term premium of long-term treasury interest rates. The problem, though, is that these developments were all happening well before 2007, the period when long-term treasury yields began their now 5-year decline. Something very different began in 2007 that pushed long-term treasury yields on a new downward trajectory. This sharp break is very clear in the figure below:

It is also clear in nominal treasury yields. And, as everyone knows, what began in 2007 was the economic crisis from which we have not fully recovered. The crisis has lowered both the expected path of short-term interest rates (because of ongoing expected economic weakness) and the term premium as investor flock to the safety of treasuries. A robust recovery, where investors returned to private safe assets, should reverse both of these developments and push yields closer to their pre-crisis values. This cyclically-driven drop is yields is not that different than the one during the Great Depression. Then too, yields were depressed for a long time since the economy was depressed for a long time.

For these reasons, we need a NGDP level target now more than ever.

P.S. Thanks to Ed Bradford for the Bloomberg figures.

Update: I originally had the below picture in the post, but decided it would be better down here. It is former gubernatorial candidate Jimmy McMillan agreeing with me:

Tuesday, January 15, 2013

Are we headed toward a brave new world of perpetual liquidity traps? Steven Randy Waldman says yes. He believes the Fed will continue operating in a zero lower bound-like environment going forward, even after the economy has recovered and interest rates return to more normal levels:

What I am fairly sure won’t happen, even if interest rates are positive, is that “cash and government debt will no longer be perfect substitutes.” Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate... Printing money will always be exactly as inflationary as issuing short-term debt, because short-term government debt and reserves at the Fed will always be near-perfect substitutes. In the relevant sense, we will always be at the zero lower bound...In this brave new world, there is no Fed-created “hot potato”, no commodity the quantity of which is determined by the Fed that private holders seek to shed in order to escape an opportunity cost. It is incoherent to speak, as the market monetarists often do, of “demand for base money” as distinct from “demand for short-term government debt”...

Waldman's statement generated swift responses from PaulKrugman and Scott Sumner who disagree. They argue that currency and short-term debt will continue to be different even with the continuation of the Fed's interest payment on excess reserves (IOER). Both sides are making, I believe, reasonable claims but are assuming different future paths for the IOER. This difference is key to reconciling their views.

Here is why. First, the IOER is not truly new. Although the IOER was introduced in late 2008, we implicitly had the IOER all along, it was just 0% in the past. The key development was not its explicit introduction, but its taking on a positive value that was by most accounts above the equilibrium (or "natural") interest rate on other short-term safe assets (i.e. treasury bills). By late 2008, the U.S. economy was free falling and along with it went the equilibrium treasury bill rate. The Fed, in its infinite wisdom, decided to keep the IOER above the falling treasury bill rate and thus further increase the already elevated demand for bank reserves. In other words, the explicit introduction of the IOER mattered because it effectively tightened monetary policy. Going forward, the IOER will again matter based on where the Fed moves it relative to the equilibrium treasury bill interest rate. This is because the current and expected path of this spread will determine the stance of monetary policy. And what happens to this spread will also determine whether bank reserves do or do not remain perfect substitutes for treasury bills.

For example, assume the Fed does not sterilize the monetary base and keeps the IOER at 0.25% as treasury bill yields increase in response to the improving economy. Banks (and their creditors) now have a incentive to invest in treasury bills and other higher yielding assets, triggering a cycle of portfolio rebalancings (i.e. the "hot potato" effect). At the same time, the demand for financial intermediation increases owing to the improved economic outlook. Banks respond to this increased demand by creating more loans. As part of the recovery, the transactions demand for money will also increase and some of it will take the form of increased demand for currency. The unsterilized monetary base will therefore change composition toward more currency. This means there still can be a difference among the demands for currency, bank reserves, and treasury bills in our brave new world.

The key to this particular scenario, though, is that the IOER remains below the equilibrium treasury bill interest rate. The opposite outcome will unfold if the former rises above the latter. Steve Randy Waldman's scenario of no Fed-created hot potato effect and no difference between the monetary base and treasuries can also be true if the Fed manages to keep IOER equal to the equilibrium treasury bill yield. The key, then, to reconciling the Waldman-Krugman-Sumner debate is understanding where each commentator assumes the IOER will be relative to the treasury bill natural interest rate. The table below summarizes the different scenarios:

Now what if we had a truly cashless society? Scott Sumner argues that even in this scenario there can still be a Fed-created hot potato effect:

Now let’s suppose we have a cashless economy, just interest-bearing
reserves. The base is one trillion dollars and NGDP is $20 trillion.
People prefer to hold base money equal to 5% of NGDP. Now the Fed
wants to double NGDP, to $40 trillion. How do they do this? They could
adjust the quantity of base money. But let’s rule that out. We’ll
have them adjust the demand for base money by changing the IOR. So
let’s say they cut IOR until the public prefers to hold reserves equal
to 2.5% of NGDP. If the stock of reserves is unchanged, there will be
an excess supply of reserves at the new IOR. The hot potato effect will
take over, and raise prices and output until NGDP has doubled. Then we
will be in equilibrium again. So the hot potato effect refers to
changes in both the supply and the demand for base money. There is
nothing particularly “monetarist” about the hot potato effect.

Although Sumner does not explicitly state it, here again the key is where the IOER will be relative to the equilibrium treasury bill interest rate. The table below summarizes the cashless scenarios:

Of course, all of this discussion is premised on the Fed continuing to use a short-term interest rates as its operating instrument (technically, its intermediate target). If, on the other hand, the Fed started targeting, say, a NGDP growth path and used the monetary base as its operating instrument, this entire discussion would be moot. But that is not the world we live in, so until that time keep your eyes on the IOER-treasury yield gap.

Update: Josh Hendrickson emails me the following discussion:

I think that what people are missing is the dynamic path of
adjustment. Let's suppose that we live in a world where the Fed conducts
policy using IOER. You are correct that if they lower the IOER, this
should push banks to reduce their reserve holdings by buying Treasuries and
other assets whose relative rates of return have risen to the point that they
now make sense to own given IOER. This should indeed lead to a
corresponding change in the composition of portfolios and spending. This
is the dynamic adjustment path. This adjustment continues until relative
rates of return adjust. Thus, one would think that the yield on T-bills
would adjust such that banks are indifferent between bank reserves and T-bills.
Waldman seems to think that we instantaneously move from one equilibrium
to the next and that it is the reduction in interest rates that is all that
matters. In other words, what Waldman is really arguing is that with
IOER, we are in a New Keynesian fantasy world where the central bank pins down
the interest rate and everything adjusts correspondingly. I remain
unconvinced that the interest rate is sufficient to pin down equilibrium.
But more importantly, I am convinced that monetary policy works through
more than one transmission mechanism. If it only works through the
interest rate, then monetary policy is always and everywhere (not just at the
ZLB) pretty weak in the context of countercyclical policy.

Update II: The real authority on this issue is none of us bloggers, but Peter Ireland of Boston College. He has the foremost paper on this issue.

Monday, January 14, 2013

One of the biggest challenges facing the global economy is the shortage of safe assets, those assets that are highly liquid and expected to maintain their value. This shortage matters because safe assets facilitate exchange and effectively function as money. AAA-rated CDOs, for example, served as collateral for repurchase agreements which were the equivalent of a deposit account for institutional investors in the shadow banking system. Therefore, when many of these CDOs disappeared during the financial crisis, a large part of the shadow banking system's money disappeared too. This precipitous decline in institutional money assets declined occurred, of course, just as the demand for them were increasing because of the panic. This problem bled over into retail banking, since it was funded by the shadow banking system, and forced many retail financial firms and households to deleverage. This deleveraging, in turn, meant fewer retail money assets just as panic was kicking in at the retail level. In short, the shortage of safe assets is a big deal because it means there is an excess demand for both institutional and retail money assets. This broad excessmoney demand is why aggregate nominal expenditures in many countries remain depressed. A full recovery, then, will not happen until there is a sufficient stock of safe assets.1

So what can be done about this problem? Matthew C. Klein of The Economist believes the solution is for the government to create more safe assets until this excess demand is satiated. He argues that governments who control their own currency are the only producers of safe assets since there is no chance they will default. They can always create money to pay off their creditors. He sees privately created safe assets, on the other hand, as only having transitory "safeness"as evidenced by the history of AAA-CDOs and other private-label assets that went bust during the financial crisis. Private debt instruments, therefore, cannot solve the safe asset shortage problem according to Klein. Instead, the road to full recovery can only be paved with fiscal policy creating more safe assets.

I take a different view: a robust recovery canonly occur if there is an increased confidence in the safety of private debt instruments (i.e. a drop in the risk premium) and, as a result, an increase in demand for them. Afull recovery, therefore, requires arestoration of the market forprivately-produced safe assets. Klein does not believe this is possible, I do. Here is why I hold this view.

First, there are no truly safe assets, only ones with varying degrees of safeness. This is true even for governments that control their own currency. Yes, they will never explicitly default since they can create money to redeem their liabilities, but they can still implicitly default bycreating higher-than-expected inflation. In other words, investors worry about inflation risks too when looking for safe assets. The U.S. learned this lesson the hard way in the 1970s as seen in the figure below. It shows foreigners reduced their holdings of treasuries when inflation soared:

We are a long way from the 1970s as evidenced by theongoing demand for U.S. treasuriesand the resulting low yields(and no, the Fed is not behind this development). Still, the U.S. government faces a tension. It can run larger budget deficits to meet the global demand for safe assets, but doing so may eventually jeopardize its risk-free status,the very thing driving the demand for its securities. This is the modern version of the Triffin dilemma and it reminds us that there is a limit to how much safe asset creation can be done by the government.

This point is underscored by the fact that the supply of U.S. private safe assets has been significantly larger than the stock of U.S. government safe assets, according to the Gorton et al. (2012) measure of safe assets:

Consequently, it would be unlikely that the U.S. Treasury could create
enough securities to fill the gap created by the shortage of private
safe assets without undermining the safe asset status of treasuries. To be concrete, if we follow Michael Belongia and Peter Ireland's recent paper, where they solve for the optimal amount of
money (or safe assets) by plugging in potential Nominal GDP (as estimated by the
CBO) and actual trend money velocity (as estimated by the
Hodrick-Prescott filter) into the equation of exchange (i.e. M*t= NGDP*t/V*t ), the safe asset shortfall for the U.S. economy at the end of 2011 was just over $4 trillion. Can the U.S. government really run up 4 more trillion dollars in debt,
on top of the existing debt run up since 2008, without raising concerns
about its safe asset status? And that is before we even consider the non-U.S. demand for U.S. safe assets.

It seems unlikely, therefore, that the U.S. government can produce enough safe assets without harming its risk-free status. But then it does not have to do so. As I noted above, the public's perception about the safety of private assets can change given the right impetus and lead to an increase demand for privately-created safe assets. Another way of saying this, is the relatively high risk premium on private debt is probably not the result of long-run economic fundamentals. It is more likely the result of self-fulfilling excess pessimism that has put the economy in a suboptimal equilibria (as shown in Roger Farmer's work).

If this is this case, then what is needed is a major slap to the market's face. I believe an ambitious NGDP level target that significantly raised expected
nominal income growth would do just that. If credible, it would both reduce the excess demand for safe
assets (because of greater nominal income certainty going forward) while
at the same time catalyze financial firms into making more safe assets
(because of the improved economic outlook and the related increased demand for financial intermediation). For example,
imagine how the public would respond if the Fed suddenly announced
Scott Sumner's proposal of raising their asset purchase amounts by 20% per month until some
NGDP level target was hit.2 That would be the monetary policy equivalent
of shock and awe and should catalyze the market for privately produced safe assets.

But don't take my word for it. The figures found here show the estimated dynamic relationships between positiveshocks to expected NGDP growth rate and a number of economic variables, including the Gorton et al. (2012) supply of private and public safe assets for the period of 1968:Q4 - 2011:Q4.3 It shows for this period, that a sudden and permanent rise in the expected growth of NGDP leads to a rise in the supply of private safe assets and a decline of public safe assets. The former response makes sense for the reason laid out above, while the latter response follows from the fact that a large part of the budget balance is cyclical. The results also show that the risk premium (10 year treasury yield minus Moody's corporate AAA yield) and unemployment rates decline after the shock. The second figure at the link shows the same system now estimated with the private and public safe assets combined into one series. It reveals that overall safe assets increase.

The resolution to the safe asset shortage problem, then, is monetary policy catalyzing the private sector into recovery. Fiscal policy can help, but is limited by the size of the problem.

Update: Using the same estimated system above, here are the responses to a positive unemployment rate shock (i.e. an unexpected increase in the unemployment rate). Now public safe assets increase, private safe assets fall, and the risk premium rises. These results and the ones above are consistent with studies such as Bansal et al. (2011) that show public and private safe assets serve as complements in providing liquidity services.

1What I am describing here a recovery from a cyclically-induced shortage of safe assets.This is different than the longer-term, structural safe asset problem that existed prior to the crisis. This longer-term problem is the result of global economic growth over the past few decades that has outpaced the capacity of the world economy to produce sufficient safe assets. See this earlier post for more on this point.

2 The key here is to do (or at least threaten to do) open market operations (OMOs) that permanently
raise the expected level of the monetary base. When this happens,
expected nominal incomes will be higher too and lead to the responses
outline above. Thus, even though OMOs at the zero lower bound might be
trading near substitutes--monetary base for treasuries earning 0%--the belief that
they won't stay near substitute because of the permanence of the
monetary base injection will trigger a portfolio rebalancing effect that
will lead to higher nominal spending.

3This isestimated using a vector autoregression (VAR). The data are quarterly, in log levels unless already in growth rates, and estimated using 5 lags. The generalized impulse response function is used here so that ordering of the variables in the VAR does not change the outcome. The sample begins in 1968:Q4 because that is the earliest data point for the expected NGDP growth series. This series comes from the Survey of Professional Forecasters.

Monday, January 7, 2013

Michael Woodford continues to do God's work on the pages of the Wall Street Journal and an in an interview with Bloomberg. In the former, he, along with Frederick Mishkin, advance the case for nominal GDP (NGDP) level targeting by showing how the current innovations to Fed policy are effectively a step in that direction. They carefully point out these changes allow for catch up aggregate demand growth while still anchoring long-run inflation expectations, the very essence of a NGDP level target. Woodford further expounds on this idea in his Bloomberg interview.

This is an important point, because many see nominal GDP level targeting as giving license to the Fed to do excessive money creation. On the contrary, it provides a solid long-run nominal anchor while allowing inflation to move in response to supply shocks in the short-run. Here is how I described it earlier:

A level target anchors long-run
inflation expectations, but allows for temporary catch-up growth or
contraction in NGDP so that past misses in aggregate nominal expenditure
growth do not cause NGDP to permanently deviate from its targeted
path. Woodford notes that currently NGDP is anywhere from 10-15% below
its trend (and thus expected) growth path. Any increase in inflation
under this target, therefore, would not be some ad-hoc temporary
increase but part of a systematic approach that would return NGDP to its
trend. I have used the following figure before to illustrates this
idea:

The black line has NGDP growing at a 5% annualized rate. Then, at time t a negative aggregate demand (AD) shock causes NGDP to contract through time t+1.
There is now an a NGDP shortfall. To make up for it, the Fed must
actually grow NGDP significantly faster than 5% to return aggregate
nominal spending to its targeted level. For example, if NGDP fell 6%
between t and t+1 it is now 11% under its trend. Next
period the Fed must make up for the 11% shortfall plus the regular 5%
growth for that period. In short, the Fed would need to grow NGDP about
16% between t+1 and t+2 to get back to trend. There
might be temporarily higher inflation as part of the rapid NGDP growth,
but over the long-run a NGDP level target would settle back at 5%
growth. Nominal and thus inflationary expectations would be firmly
anchored...Woodford also notes that such a rule would actually tend to reduce AD
shocks since it would create well-anchored nominal spending and nominal
income expectations that wold prevent such a shock from materializing in
the first place:3

A commitment not to let the target path shift down means that, to the
extent that the target path is undershot during the period of a binding
lower bound for the policy rate, this automatically justifies
anticipation of a (temporarily) more expansionary policy later, which
anticipation should reduce the incentives for price cuts and spending
cutbacks earlier, and so should tend to limit the degree of the
undershooting. Such a commitment also avoids some of the common
objections to the simple Krugman (1998) proposal that the central bank
target a higher rate of inflation when the zero lower bound constrains
policy.

And since it ignores supply shocks--e.g it would allow positive productivity shocks to result in lower inflation as long as NGDP growth was stable--NGDP level targeting tends to avoid swings in the stance of monetary policy that can be destabilizing. The future of monetary policy is NGDP level targeting.